How far behind the curve is the Federal Reserve in fighting inflation?

“More behind than you’ve ever seen them,” said David Dredge, Chief Investment Officer of Convex Strategies. “Unlike anything we’ve ever seen other than maybe the early 1970s.”

Doubts around the Fed’s ability to tame rising prices, as well as the path for tapering asset purchases, was the main topic of discussion at Optiver’s Global Volatility Webinar on February 9. Dredge spoke about the drivers of cross-asset volatility alongside panelists Alexis Maubourguet of Lombard Odier and Optiver traders Adam Cohen and Steve Sanford.

While 60% of respondents to a webinar poll predicted the Fed will hike rates three to four times this year, “the bigger risk is that three or four turns out to be not nearly enough,” said Dredge.

Plenty of volatility has coursed through rates and equity markets in 2022, with at least one measure showing Nasdaq futures swinging around at twice the pace of last year. That’s been reflected in extreme positioning across global derivatives markets, according to Optiver traders.

“Volatility buying in the front end, with no real reprieve,” is how Cohen, head of eurodollar options trading in Chicago, described the U.S. rates market. That’s been exacerbated by a “significant” lack of liquidity that if unchecked threatens “wide dislocations in volatility, high vol-of-vol and wider spreads,” he said.

It’s a similar story for stocks, according to Sanford, senior trader in global equity index options in Amsterdam. “There’s a lot of fear driving these short-term moves,” he said. “A lot of volatility around central bank events. High realized volatility environment with high dispersion.”

Collectively, these factors have laid waste to 60/40 portfolios, with the strategy clocking its worst month in January since the start of the pandemic. So how can investors position themselves for this uncertain environment?

“Buy equities and buy volatility,” advises Dredge. Maubourguet believes that beyond participation (beta) and protection (convexity), there is room for alpha (true diversifiers, i.e. with zero effective beta) in a balanced and robust portfolio. He recommends looking into a “next decade” portfolio comprising 60% equities, 20% fixed income and 20% “true alternatives.”

Both investors say that with equity and rates volatility looking expensive, they see opportunities in the FX market to source long-volatility and convexity trades.

In the meantime, keep a close eye on economic data and be ready for policymakers to react, panelists said.

“The central banks have made clear that they are data dependent and have no clear path in mind,” said Maubourguet. “When they say they don’t know where they are going, I see no reasons not to believe them, and it means that each and every data point has the potential to be a market mover. This is adding volatility to the market.”